corporate finace : replacement decision question

aroranidhi2004
Finance Junkie
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corporate finace : replacement decision question

Postby aroranidhi2004 » Tue Feb 24, 2015 4:01 pm

Can someone please help me with the following question?

Which of the following statements about the replacement decisions is least accurate?
A. Any loss on the sale of old equipment is multiplied by the tax rate and is treated as initial cash outflow.
B. the present value of additional depreciation expense on the new equipment ( as compared to the depreciation on the old equipment) multiplied by the tax rate is treated as an operating inflow.
C. The present value of the after-tax benefits of a cost reduction resulting from a new investment is treated as an operating inflow.

Regards,
Nidhi

edupristine
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corporate finace : replacement decision question

Postby edupristine » Wed Feb 25, 2015 4:23 am

Hi, answer to your question option "A". This is because loss on sale of old equipment is multiplied by tax rate and treated as CASH INFLOW. It results in tax savings for recognizing it as a loss.

aroranidhi2004
Finance Junkie
Posts: 41
Joined: Thu Oct 16, 2014 4:51 pm

Postby aroranidhi2004 » Wed Mar 04, 2015 5:19 pm

Can you please explain why it is A or can you please explain it in details?

Regards,
Nidhi

edupristine
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corporate finace : replacement decision question

Postby edupristine » Thu Mar 05, 2015 6:43 am

Hi,
If company sells a fixed asset less than a book value then company will incur a loss. In this situation company can save taxes or tax need not to be paid. Example book value of old asset is $400,000 and cash salvage value is $300,000. Loss will be $100,000. If we assume tax rate is 40% then total tax saved is 40% of 100,000= $40,000. When company replaces its old asset the calculation will be as follows:
Purchase of new asset (outflow) = (-) $500,000
Cash Salvage value of old asset (inflow) = (+) $300,000
Tax saved on loss of sale of old asset (inflow) = (+) $40,000
Hence, total investment in new asset = (-) $160,000


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